Social Security and Medicare’s annual checkup revealed that the recession and longer life expectancies are taxing the health of the entitlement system. The Social Security Board of Trustees report found that program costs will exceed tax revenues in 2016, a year sooner than predicted in last year’s report. The trust fund will be exhausted in 2037, four years sooner than the 2008 estimate. Here’s a look at how the projections could affect your retirement plans.

Smooth sailing for the baby boomers. In 2037, the year the trust fund is currently projected to be depleted, the youngest baby boomers, currently age 45, will be 73. It’s highly unlikely that baby boomers will face a rise in the retirement age or cuts in benefits. “The good news for current beneficiaries and those nearing retirement is that your benefits will remain secure and intact for the foreseeable future,” says Nancy LeaMond, executive vice president of AARP, a lobbying group for older Americans.

Changes for younger people. Social Security and Medicare will still be around for younger generations. But there is some uncertainty about whether there will be tax increases, benefit cuts, some combination of the two, or other fixes to correct the underfunding. “You can sort of count on the fact that if there are any changes in benefits they will be in a downward direction, and then individuals like us will have to provide more of our own income through our own personal savings and our employer-provided plans,” says Bruce Schobel, president-elect of the American Academy of Actuaries. “I think it’s a very safe bet that in the process of restoring financial soundness, the government is very unlikely to expand the benefits.”

Making up the difference. Social Security currently replaces about 41 percent of preretirement income for most Americans when they retire. Americans without traditional pensions who want to maintain their standard of living after retirement need to save whatever amount they need above that on their own. We don’t know exactly how the government will recalibrate the retirement system to fix the shortfall, so younger Americans can’t calculate precisely what their retirement benefits will be. But it can’t hurt to save or invest a little extra cash in case benefit amounts decrease.

Longer life expectancy. In addition to the recession, Americans’ increasing life expectancy is contributing to the depletion of the Social Security trust fund. “Americans are living slightly longer than we’d previously assumed,” says Andrew Biggs, a resident scholar at the American Enterprise Institute and a former deputy commissioner of the Social Security Administration. “Increased longevity means more people collecting benefits for longer, which is a recipe for larger deficits.” Americans now generally live 17 to 19 years after age 65, up from 12 to 13 years in 1940. The Obama administration has said it does not have plans to raise the retirement age and instead favors plans to raise Social Security payroll taxes for those making over $250,000 a year by 2 to 4 percent (combined employer and employee), but a future administration could. Younger workers may want to plan to work a few years past their current full retirement age, 67, for their own financial security. Working just an extra year or two is one of the quickest ways to pad your retirement accounts and reduce the number of years over which your savings must be spread. Plus, under current law, Social Security payouts increase for each year you delay signing up between age 62 and 70.

Making Medicare healthy. Medicare’s funding ailments are expected to occur even sooner than Social Security’s. Projected annual assets for the hospital insurance portion of Medicare are expected to exceed expenditures by 2012. The hospital insurance trust fund is expected to be exhausted by 2017, two years earlier than projected in last year’s report. Medicare Part B, which covers doctors’ bills and other outpatient expenses, and Part D prescription drug coverage are more adequately financed in the short term, but increases in healthcare costs over the long term will average 6.4 percent annually and require increases in enrollee premiums and general revenue funding.

Most current retirees will not be subject to large premium increases in the short term because of a law that limits premium increases to the dollar amount of the annual increase in Social Security benefits. A Congressional Budget Office report predicts that there will be no cost-of-living increases for Social Security beneficiaries in 2010 through 2012, which also means no Medicare Part B premium hike for the majority of beneficiaries. But new enrollees and current beneficiaries with incomes above $85,000 this year ($170,000 for couples),who make up approximately one quarter of Part B enrollees, could be charged unusually large premium increases over the next two years. Premiums for Medicare Part B and D and the prices for out-of-pocket medical expenses not covered by Medicare are likely to further increase in the future.

The Problem with Debt

15.4 million homeowners now owe more on their houses than their houses are worth, up from 13.6 million four months ago. The number will probably top 20 million when all is said and done. To mark this sad stat, we’ve updated our post from last fall on the power of leverage.

Put differently, when the value of the asset drops below the value of the debt used to buy it, poof.

Nowhere is this concept more important than in the housing market. A couple of years back, the value of US residential real estate was about $25 trillion. Mortgage debt constituted about 45% of that ($11 trillion) and owner equity 55% ($13 trillion). (Very rough numbers)

Now, the value of the US housing market is down almost 30% and headed to, arguably, down 40%. In other words, if the peak value was $25 trillion, the current value is about $18 trillion, and the trough value will be about $15 trillion. So what will happen to homeowner equity? It will drop by 70%.

PEAKValue: $25TMortgage Debt: $11THomeowner Equity: $14T

TROUGHValue: $15TMortgage Debt: $11THomeowner Equity: $4T

Ouch. And by the way, that percentage holds regardless of what the actual peak value of the housing market was, as long as you start with 45% debt-to-value. Also, most of that equity is owned by folks who own their houses outright.

And what happens if you have a more typical debt-to-value ratio–say, 80% debt? Then, unfortunately, your equity IS going to zero. In fact, it will only take a 20% fall in the house price for that to happen. That’s why so many households are now underwater.

(By the way, this is what killed all those Wall Street banks. Unlike consumers, they didn’t have 45% debt-to-value ratios or even 80% debt-to-value ratios. They had 97%-debt-to-equity ratios. So it didn’t take much of a decline in equity to blow them to smithereens.)

What about stock portfolios?

The worst peak-to-trough stock market drop was 1929-1932, when the S&P 500 dropped 86%. Horrific, but not zero. (Unless you were carrying margin debt). But here’s keeping our fingers crossed that the S&P 500 bottomed when it was down 56%.

And, to close on a happier note, here are some things that almost definitely aren’t going to zero:

Consumers that have enough cash flow that they won’t get forced out of their houses when their equity is zero (the house prices will eventually recover, and then the same leverage will work on the upside).

Investors who don’t panic and sell stocks at the bottom. As long as the portfolio is diversified and the companies don’t go bankrupt–see below–the prices will eventually come back.

Companies with no debt and strong cash flow that would still generate cash if you cut their revenue significantly.

Fitch Ratings-New York-13 May 2009: The par value of U.S. corporate bonds affected by downgrades hit a high of $522.4 billion in the first quarter (up from $391.5 billion in the fourth quarter of 2008), resulting in a downgrade rate of 14.5%, as the financial and economic crisis continued to take a toll on corporate credit quality, according to a new Fitch report.

The first quarter of 2009 also saw another unwelcome milestone as the share of U.S. corporate bonds rated ‘AAA’ fell below 1% of market volume while the share of ‘CCC’ rated issues moved up again to a new high of 6.8%. In total, the ‘AAA’ category saw $176.2 billion in downgrades while the ‘AA’ category featured an additional $142.1 billion.

A positive development in the first quarter was a strong rebound in issuance, tallying $184.9 billion following dismal third- and fourth-quarter 2008 activity of just $80.8 billion and $74.4 billion, respectively. While an impressive turnaround, this strength came from highly rated, defensive industrial names. Financial and speculative grade issuance remained very low.

Options Trader: Thankful Friday

We cashed out our longs, as planned, very close to the top and yesterday, at 1:47, I sent out an Alert to Members titled: “Not Being Greedy With May Shorts” in which I said: “At this point, with our put plays all back in black – we need to start stopping out if they get the market back over 8,400 (our goal was to get to cash and this is a gift). With a 50 point Dow trailing stop if we head lower than 8,360. Ideally, we should be out of any May puts (or May anythings) and cautious about June. If it’s a real sell-off, we use the cash to scale into June puts (which would include FAZ calls of course).” That was a FANTASTIC call (if I do say so myself) as we bottomed out at 8,358 at 3:33, by which time we were already cashed out ahead of the usual stick save.

It was a perfect day as we stuck with our plan from Wednesday night to press our short bets into the gap up open we expected, and we’re now in cash and are likely to day-trade a few short-side bets this morning but cash is still going to be king going into the weekend. This will be a short post as I am already working on our next round of bank plays for members as we also cashed out most of our sample $100,000 Hedged Portfolio ahead of the stress tests and are itching to take up some new positions so I wrote a new post entitled “Stress-Free Investing In Stress-Tested Banks” with plenty of new entries we’ll be looking to make into next week.

The Jobs report showed a loss of “only” 539,000 jobs but last month was revised up 69,000 which everyone seems determined to ignore. Unemployment is up 0.4% to 8.9%, the worst since Sept 1983. If the government hadn’t added 72,000 jobs (mostly census workers) this would not be at all pretty so we will be shorting the Dow at the open as a day trade and taking off our put covers against our long DIA puts, perhaps recovering into the weekend if we get a nice sell-off.

Oil is back at $58 so we’ll be shorting that into the weekend (I’m shorting the futures now below $58 with a stop there) as Toyota (TM) and Honda (HMC)gave poor reports with poor outlook. We know our auto industry sucks but if those two can’t sell cars either then the people buying oil are certifiable and we are happy to take their money.

Asia was up a point and Europe is up about 1.5% on bank fever but I see projected losses of up to $599 (not $600) BILLION by our 19 largest banks alone if the economy does not improve. So forgive us if we hold onto our cash over the weekend while we wait for people to sober up.

William Waller and Jason Stock, founding partners of M3 Funds, recently wrapped up their presentation at the Value Investing Congress, entitledBanks: Have We Seen the Worst of It? The following are our notes.

M3 Funds: Investing in Under-followed Banks

Manage a long/short equity fund focused on the U.S. Banking Thrift Sector. M3 focuses on under-followed banks. There are 1,300 publicly traded banks, 5,500 private banks, 700 mutual banks and 7,900 credit unions. M3 focuses on publicly traded banks—93% of which have a market cap below $500 million. Jason believes he has a competitive advantage in investing in under-followed banks.

He views a bank as a leveraged play on the market in which it operates. M3 conducts research on individual banks through extensive travel, public records searches, private banks and credit unions, FDIC data—call reports, real estate agents and developers.

State of U.S. Banking Sector

Sector is significantly under-capitalized. This is the sector’s #1 problem.

Credit quality has deteriorated and will continue to deteriorate.

The number of bank failures is accelerating.

Tangible equity/asset ratios have “fallen off a cliff” in 2007-08 and are 4%-5% vs. historical levels of 6%-7%. These ratios are not sufficient to handle the losses that will come in the future.

Where we are headed: Commercial real estate (CRE), consumer loans (auto, credit cards)—have yet to see meaningful deterioration on many banks’ balance sheets. Auto loans have held up rather well but he’s starting to see deterioration in this category of loans.

Jason sees a significant amount of bank failures in the future. There have been about 30 bank failures YTD. He sees this number rising to 150+ by the end of the year. He said that regulators might be overwhelmed (not enough staff) and thinks that they could shut down over 100 banks right now if they had enough people.

Can TARP, TALF, PPIP, accounting changes help? They will help some banks, but not all.

State of Commercial Real Estate

Unemployment will continue to rise and commercial real estate is the next shoe to drop.

Roughly 25% of all CRE is securitized, most of which was originated between 2002-07 and is now beginning to come due.

CRE vacancies are rising—commercial foreclosure process is just beginning, which will impact all commercial values and CAP rates.

The primary problem areas include: retail strip centers and office.

Investment Approach: Criteria for Long Positions

Low price to tangible book value, excess capital

Low loan to deposit ratio

Attractive markets (looks at real estate and employment trends—likes state capitals and university towns for longs since these provide a very stable job base)

Bearish management team

Share repurchase plan

Attractive deposit base

Excess capital is the number one statistic that M3 focuses on

Jason also said that a bank’s biggest asset is its liability base (deposits) and a bank’s biggest liability can be its asset base (loans)—he views the deposit base as a hidden asset.

The Fed’s current actions are creating long-term risks for the banking sector and the broader economy. Common stockholders are at risk in the majority of banks.

Recommendations for investors:Find a niche and become the ultimate expert. Utilize technology and creative strategies to gather information. Timing the market is difficult; develop a firm thesis and be disciplined. Manage risk well—never concentrate a portfolio in one investment. Always ask yourself if you have a competitive advantage. Don’t just read it or hear it—go see it for yourself.

Q&A: Which banks do you think are zeros? Very small, obscure community banks would be high on the list. He thinks that Citigroup (C)and Bank of America (BAC) common shareholders could potentially get wiped out.